Oil Prices Drive Inflation Above Wages: A Blip, Not A Trend

Man pumping gasoline, checking prices.

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The increase in consumer prices exceeded wage growth over the past 12 months, with near panic from some reporters. The numbers show wages rose 3.6% but consumer prices increased by 3.8%. This disparity is a short-run blip, not a long-lasting trend.

The long run trend is that employee compensation rises faster than inflation, but with exceptions. The recent run-up of inflation came mostly from energy, where prices rose by 18% in the past 12 months. The rest of the Consumer Price Index rose just 2.8%.

Historically, sharp run-ups in oil prices often coincide with total inflation exceeding wage growth, but only briefly. When inflation rises persistently, it’s invariably due to excessive stimulus in the economy, which often goes on and on and on. In these cases, wages rise faster than prices. But a bump in inflation that is caused by a spike in oil prices does not persist.

High oil prices breed their own reversal. The run-ups of 1973 and 1979 pushed oil up to $40 a barrel. That led to energy conservation by both consumers and businesses. More importantly, it led companies to search for more oil. By 1986 oil was below $12 per barrel. That brought overall inflation below the pace of wage gains.

Another oil prices surge came again in 2008, due to the growing world economy pushing petroleum demand up faster than supply increased. (This was a little-noticed contributing factor to the Great Recession.) When oil prices reversed course, falling 42% in a 12-month period, inflation not only fell but turned negative for a while. Wages continued to rise, helping workers enjoy a higher standard of living.

Today’s oil prices will come back down at some point. The timing depends on the outcome of the Iran War and the reopening of the Strait of Hormuz. These events I am not able to forecast. Overall inflation will come down and drop lower than the pace of wage gains.

This prediction of inflation-adjusted wages rising does not depend on Federal Reserve anti-inflation policy, at least not generally. The timing of Fed policy, and the magnitude of their tightening, could push wages down faster than inflation for a brief period of time. The Fed has a difficult job to do, and even the best people cannot handle monetary policy well enough to avoid overshooting in one direction or another. But the long-run fundamentals demonstrate that so long as worker productivity grows, wage rates will rise faster than overall inflation.

The bottom line for workers and businesses alike: do not mistake a temporary oil-driven squeeze for a permanent shift in living standards. History is consistent on this point —inflation spikes from an energy shock do not cause long-lasting reductions in workers’ purchasing power. The current discomfort is real, but it is a detour, not a new destination.